Microsoft (MSFT) has announced their decision to pay a hefty premium of $44B for Yahoo (YHOO). In perspective, that amounts to 60 times Yahoo’s projected 2009 earnings. The irony is that Microsoft had issued to its shareholders a special dividend not too long ago with the surplus cash that was available at that time. Had there been enough foresight Yahoo could have been purchased earlier for far less than the current premium without having to borrow money to fund the acquisition.

Microsoft and Google are valued at 14 and 25 times respectively of their forward earnings. Their size dictates that it will be tough for them to grow earnings at a healthy rate going forward resulting in mediocre returns for investors as explained in our article on Google valuation last year. Apart from the modest arbitration opportunity available to purchasers of Yahoo shares and short-term trading opportunities due to the volatility in Google shares, returns are limited for long-term growth investors in shares of either of these companies.

Meanwhile the smaller companies in the Internet advertising space, Valueclick (VCLK), Local.com (LOCM), Baidu (BIDU), and Rediff (REDF) should notice a relative short-term appreciation in their valuation as investors adjust the premium expectation in an acquisition. In the long run, it is unclear how well these niche players hold up.

Both Google and Microsoft are trying to monopolize the Internet Display Ad pie which will initially be in their favor. Infrastructure is in place for both these giants, whereby an undisclosed percentage of advertiser money generated from ads in publisher content is siphoned off through their advertising platforms. The publishers stand to lose in this situation. This has resulted in venerable media companies like the New York Times (NYT) and the Gannett Company (GCI) being valued at a significant discount. The situation is analogous to toll operators getting valued at a large premium compared to owners of private roads. The justification being toll operators can decide to collect any amount they like and can control how much they provide to the owners of the private roads for which they collect the toll. Needless to say, such a situation is unfair to the owners of the private roads who will end up considering other options to collect toll. Longer term, Internet publishers will decide to move away from Google’s and Microsoft’s advertising platforms and instead weigh alternatives that allow a very minimal overhead cost and the majority of the revenue stays with the publisher. That will be the beginning of the end for Google’s and Microsoft’s lucrative display ad businesses.

Google is an outright winner in the horizontal search area and should continue to dominate for the foreseeable future. The real threat for Google is that area slowing down due to limitations of text-based Ads that show up as part of search results. The AdSense product has been categorized as good at monetizing crap. This is even truer for Google’s horizontal search area. The weakest link here is Google being dependent on users structuring their search queries so as to accurately depict their objective as otherwise the in-context Ads will be as useless to the user as the search results. Such a requirement is taxing for the user and better alternatives will be introduced into that market space over time.

To recap, Microsoft appears to be making wrong moves in its effort to displace Google. Acquiring media assets while they are cheap and using the Ad platforms to accelerate monetizing the assets may be a better overall plan. Further, Display-Ad verticals are an area that will catch up to fetch a growing portion of the total Internet Ad revenue. As that happens, a lot of the advantage that Google and Microsoft enjoy will whittle down unless they make a concerted effort in growing on to those areas.